Saving For Your Child’s Education

The cost of education continues to rise each year, so it is helpful to be aware of some programs that allow parents to save for the cost of their children’s education.

A parent can make contributions to a qualified tuition program (commonly known as a 529 Plan) or an education savings account (commonly known as Coverdale savings accounts) as a way to save for their children’s education. There are many similarities between the two saving vehicles but there are also major differences, which are listed below.

Key Similarities

Distributions from these accounts are not taxable as long as they are used for qualified expenses. So if the account accumulates a few thousand dollars of earnings over its lifetime, those earnings escape taxation. If the distributions are not used for eligible expenses, the earnings portion are taxable and are also subject to a 10% penalty.

A taxpayer does not receive a deduction on their federal income tax return for contributions made to either account. However, some states like Pennsylvania and Maryland allow deductions for contributions to 529 programs.

Expenses paid with distributions from these accounts cannot be taken into account when claiming educational tax credits nor as deductions on personal income tax returns.

Contributions made to these accounts on behalf of beneficiaries are treated as gifts. Gifts made in excess of $14,000 require the filing of a federal gift tax return and could result in gift taxes or the use of the taxpayer’s lifetime exemption. However, it is important to note that payments made directly to an educational institution would avoid gift and generation skipping taxes.

A student’s financial aid may be impacted by these plans. Generally, accounts opened by the student or the parent are considered owned by the parent for financial aid purposes while an account owned by a grandparent does not count as an asset. A maximum of 5.64% of parental assets are counted in the financial aid calculation compared to 20% for assets considered owned by the student. Distributions received from accounts owned by parents or a student do not count as income for financial aid purposes. However, distributions from an account owned by a grandparent could reduce a student’s financial aid for the following year by 50% of the distribution. Therefore, it may be a good planning idea for grandparents to gift funds directly to parents and have the parents contribute to a plan. If that is not an option, it would be best for the student to use funds from a grandparent’s plan when it is likely that financial aid won’t be available the following year since current year distributions only impact the following year’s formula.

Key Differences

Contributions cannot be made to education savings accounts if joint income exceeds $220,000 ($110,000 for single filers)

Contributions to education savings accounts can only be made if a beneficiary is under the age of 18.

Contributions to education savings accounts are limited to $2,000 a year while contributions to qualified tuition programs are limited to the amount necessary to provide for the qualified expenses of the beneficiary as determined by the plan (Usually capped at $200,000 for most plans).

Contributions to qualified tuition programs can be treated as made ratably over a 5-year period for Federal gift tax purposes. Therefore, a potential gift tax could be avoided as long as it does not exceed five times the annual exclusion of $14,000. For example, if a grandparent contributes $70,000 to a plan for his grandchild in a given year, the $70,000 could be treated as a contribution of $14,000 each year over a 5-year period. However, in order to receive this special treatment, a taxpayer must file a gift tax return and make the election.

In addition to post-secondary expenses, education saving accounts can be used for educational expenses from kindergarten through twelfth grade.

Like most things in life, it’s always best to start saving as early as possible to maximize the growth of earnings so they can be used to offset future educational needs. But it’s important to remember that earnings must be used for qualified educational expenses because the penalties can be harsh if they are not. It’s also important to know that other savings vehicles like education trusts are available. Each person’s goals and situations are different and it is best to have an understanding of all existing options.